A Sinking Sensation for Subprime Loans

The default rate for borrowers in the sector has jumped faster than anyone was expecting, raising risks for housing and the overall economy

The gathering storm clouds over the nation's housing and lending markets grow darker each day. Fueling the latest concerns is further fallout in the subprime mortgage loan market, where lenders offer financing to less-creditworthy buyers.

Global banking giant HSBC Holdings (HBC), the third largest subprime lender in the U.S., disclosed on Feb. 7 that full-year 2006 impairment charges at its U.S. mortgage unit would be 20% higher than the $8.8 billion or so that analysts had been projecting. On Feb. 8, New Century Financial (NEW), the nation's second largest lender to subprime borrowers, said it expected to report a loss for the fourth quarter, and that it would have to restate its financial results for the first three quarters of 2006 (see BusinessWeek.com, 2/9/07, "Subprime Time Bomb"). Another subprime lender, ResMAE, filed for bankruptcy on Feb. 13, bringing the total failures to 21 since December, according to www.ml-implode.com, reports Action Economics.

Wrong-footed by the rapid deterioration in subprime loans, primarily those originated in 2006, lenders such as New Century have had to buy back a growing portion of these loans, which they had sold to investors and other financial institutions, because of faster-than-expected defaults. HSBC particularly identified second-lien or "piggyback" loans (loans made above a first mortgage, generally to help buyers come up with downpayments) in its mortgage book as those that could be hurt by higher interest rates as adjustable-rate mortgages (ARMs) reset over the next few years. HSBC acknowledged that some borrowers face fewer refinancing options amid slowing growth in home prices, and limited if any appreciation in their home equity.

Slo-Mo Flashback

With national home prices appreciating at a compound annual growth rate of around 6% from 2000 through 2005, subprime loans, many of which are tied to adjustable rates and include features that allow buyers to pay only the interest or make even lower payments, blossomed in popularity. Subprime mortgages accounted for 19% of all mortgage originations in the first half of 2006, according to the Mortgage Bankers Assn.

But the recent disclosures from HSBC and New Century indicate that the slowdown in the U.S. housing market could have a larger economic impact than previously thought. As a result of rising delinquencies and foreclosures, most banks and mortgage lenders are tightening underwriting standards, a move that may limit consumers' access to credit. New Century said on Feb. 8 that its improved lending standards would result in a projected 20% decline in total mortgage loan origination volume in 2007, compared with a previous forecast of flat growth.

The trickle of bad news in recent months resembles a slow-motion version of 1998's credit crunch following Russia's debt default of that year and the unraveling of hedge fund Long-Term Capital Management. Back then, the flight-to-quality into U.S. Treasury notes and bonds, along with investors' unwillingness to purchase securities backed by subprime mortgage loans, led to the eventual bankruptcy in 2000 of companies such as ContiFinancial, a former unit of grain giant Continental Grain. An ill-timed bet into specialty lending by life insurer Conseco—which bought Green Tree Financial, a leading lender in the manufactured home market, in 1998—played a considerable part in Conseco's bankruptcy in late 2002.

Small Cracks in Big Banks

This time around, banks have pulled their credit lines to companies such as Ownit Mortgage and Sebring Capital Partners, leading to their demise. Small cracks in the mortgage-loan books at some of the nation's largest banks have begun to appear as well. Subprime home equity loans drove material increases in overall mortgage losses for Citigroup (C), JPMorgan (JPM), and Wells Fargo (WFC) in the fourth quarter of 2006, according to research by Standard & Poor's Credit Markets Services.

The homebuilding sector isn't immune. Should buyers find it more difficult to qualify for mortgages, that could add to builders' woes at a time when many of them are suffering from a glut of unsold homes and falling land prices. Toll Brothers (TOL), the nation's largest luxury homebuilder, said Feb. 8 that orders fell by 33% in its fiscal first quarter, while it expected land writedowns of $60 million to $160 million for the period, exceeding estimates disclosed in December. Centex (CTX) wrote off $435 million and KB Home (KBH) wrote off close to $494 million for land and land options in their quarterly reports released in January.

Meanwhile, banks and other financial institutions along with global investors—many of whom poured into the U.S. residential mortgage-backed securities (RMBS) market in recent years because of the attractive yields on these bonds—may be exposed to souring loans. During the runup to and peak of the recent housing boom, total mortgage credit rose by about 10% annually from 2000 to 2005. In the same period, banks and other credit institutions became more exposed to mortgage debt in the form of loans and mortgage-backed securities. Total mortgage debt outstanding at commercial banks rose at a compound annual growth rate of 11% from 2000 to 2005, and at a rate of close to 7% at savings institutions.

Worse to Come?

But credit deterioration poses pitfalls for investors. Total delinquencies for RMBS transactions issued in 2006 averaged 12.61%, and loans considered seriously delinquent averaged 5.97%, according to research by Standard & Poor's Credit Markets. And there are reports that jitters are hitting the derivatives market as buyers and sellers of mortgage credit protection battle it out, says Action Economics.

Delinquencies and foreclosures may get worse. One out of five subprime mortgages issued in the past two years is projected to end in foreclosure, according to a study released in December by The Center for Responsible Lending, a Durham (N.C.)-based research group. The group also noted that even when home prices were rising, subprime home loans fared poorly, with as many as one in eight, or 13%, of these loans ending in foreclosure within five years of origination.

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